Deflation's back in Japan--and why investors should care

The Bank of Japan is forecasting that prices in Japan will fall by 1.5% this year, by 1% in 2010, and by 0.7% in 2011.

So much for any recovery in the Japanese economy.

Deflation is indeed a symptom of the woes in the Japanese economy. It’s created by excess capacity that drives down prices since companies are willing to cut prices to keep factories running at even partial capacity. It’s a sign that Japan’s export-based economy is getting killed in competition with cheaper Asian exporters such as China and Korea. And it indicates that Japanese companies facing slow demand aren’t investing in new capacity or hiring more workers.

But a period of prolonged deflation like Japan has suffered during long patches of the last decade and looks like it will suffer again for an extended period as the country moves from the “00s” to the “teens,” isn’t just a reflection of an economy’s woes. Deflation in this setting itself creates problems. For example, once consumers and CEOs become convinced that prices will keep falling they have a built in excuse for putting off buying decisions. Everything will be cheaper in the future, right?

In addition, if prices are falling, low risk investments paying seemingly ridiculously low interest rates become reasonable choices. If you’re money is safe, it will appreciate in value as prices fall even if the yield is 0%. This discourages risk-taking and saddles the country with a vast pile of under-performing investments—a problem for a rapidly aging country such as Japan facing huge future expenditures.

What does all this mean to a U.S. investor?

It means that the U.S. dollar carry trade has a chance to unwind without sinking the prices of all the assets that traders purchased with the cheap dollars that they borrowed. When the dollar was a reliably falling currency with benchmark interest rates set by the Federal Reserve near 0%, traders borrowed dollars (essentially going short the dollar) and bought gold, commodities, commodity stocks, and shares on emerging stock markets.

That trade has started to unwind as the dollar has stabilized on prospects that the U.S. economy is moving toward sustained growth in 2010 and that raised the prospects that traders would have to sell off those assets to pay back their dollar loans. (Nobody wanted to hold onto those loans if the dollar was rising in price because nobody wanted to pay back a loan in the future with more expensive dollars.)

That’s why on so many trading days lately as the dollar climbed, commodity and emerging stock market prices all fell.

But with the Japanese economy locked into what seems to be a period of reliable deflation, traders have an alternative to their dollar loans. They can buy dollars and repay their loans and then borrow to replace those loans in yen.

With the return of deflation in Japan and the return to a depreciating yen, the financial markets seem to have entered a new phase, one in which the dollar can climb and commodity and stock prices can too. That shift will be the subject of my next post.